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    International CorporateGovernance

    Reading: Chapter 1 (pages 3-21)

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    Lecture Outline

    What is Corporate Governance?

    Internal Mechanisms

    External Mechanisms

    Convergence Measuring Corporate Governance

    Benefits of Good Governance

    What you need to remember

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    Introduction

    Company founded (owned and managed) by individual,

    family, partnership, government or company.

    Stage 1:

    Stage 2:

    Company expands by issuing more equity and debt.

    New equity holders also get voting rights as to who

    manages the company.

    Equity New Equity Debt

    Equity

    Voting Rights

    Voting Rights Voting Rights

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    Introduction

    Company founder must now choose between keepingcontrol of the company or allowing the company to be

    managed by professional managers.

    If they keep control there is a potential conflict between

    the founders and other shareholders.

    If they pass management to professional managers there

    is a potential conflict between owners and managers.

    Equity New Equity Debt

    Voting Rights Voting Rights

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    What is Corporate Governance?

    Corporate governance is about minimizing the loss ofvalue that results from the separation of ownership

    and control.

    It deals with the ways in which suppliers of finance

    to corporations assure themselves of getting a return

    on their investment.

    While corporate governance has been a hot issue in

    recent years (Enron, Worldcomm, HIH and One.Tel)it is a problem that has been around for hundreds of

    yearsAdam Smith (1776).

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    Good corporate governance practices involve: The corporate governance framework should protect

    shareholders rights.

    The corporate governance framework should ensure the

    equitable treatment of all shareholders.

    Stakeholders should be involved in corporate

    governance.

    Disclosure and transparency is critical.

    The board of directors should be monitored and held

    accountable for what guidance it gives.

    What is Corporate Governance?

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    Internal Mechanisms

    Board of Directors Board Size & Independence

    Chairman/CEO Positions

    Board Committees

    Executive Compensation

    Ownership Structure

    Concentrated versus Dispersed Ownership

    Identity of Owners

    Other Blockholders

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    External Mechanisms

    External Auditors

    Debt & Equity Markets

    Monitoring by debt holders

    Analysts

    Mergers & Acquisitions

    Legal/Regulatory System

    Common versus Civil Law

    Extent of Law Enforcement

    Recent RegulationsSarbanes Oxley Act, ASX Good

    Corporate Governance Principles

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    International Differences

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    Board of Directors

    The board of directors is responsible for overseeingmanagement and representing shareholders interests.

    US and Australia have single-tiered boards, headed

    by a Chairman of the Board. The CEO and other

    executives usually also sit on the board.

    Some other countries (Germany, Indonesia) have

    two-tiered boards. The roles and composition of the

    two boards can differ.

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    Board Size

    Boards should be an appropriate sizenot too bignot too small.

    Depending on the size of the company within the

    range of 5-15 is normal.

    If the board is too small, there is a lack of

    monitoring.

    If the board is too big, there are problems reaching a

    consensus for decision making.

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    Board Independence

    Boards should have a majority/high proportion ofoutside/independent directors.

    Outside/independent directors should have no

    personal interest in the company and therefore are

    more effective monitors.

    But, it is also a good idea to have some company

    insiders (CEO, executives) on the board to provide

    the board with a better understanding of thecompanys operations.

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    Chairman/CEO Positions

    The Chairman of the Board is responsible foroverseeing the board of directors.

    The CEO is responsible for the day-to-day running of

    the company.

    In family-controlled companies it is common for the

    same person or relatives to hold both of these

    positions. But, this concentrates power and reduces

    monitoring. Therefore, the positions of Chairman and CEO

    should be separated.

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    Board Committees

    The board of directors can delegate certain duties toboard committeesthis can provide increased

    monitoring on specific issues.

    Audit committeeresponsible for internal audit

    function and appointment of external auditor.

    Remuneration committeeresponsible for setting

    appropriate compensation for directors and

    executives. Nomination committeeresponsible for finding

    appropriate directors and executives.

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    Executive Compensation

    Compensation of top executives can be used to tie theinterests of the executives to those of shareholders.

    Variable performance packages are preferred:

    If they perform well, they are rewarded.

    If they perform poorly, they are not rewarded or fired.

    Alignment of interests is usually achieved through:

    Stock ownership

    Stock options

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    Ownership Structure

    Australian and US companies are usually owned bywidely-dispersed shareholders and controlled by

    professional managers. This means that no single

    party is in control of the company.

    However, in other nations around the world,

    ownership is usually concentrated in the hands of

    family groups or government entities. This means

    that one group is in control of the company and thereis very little you can do (other than sell) if you dont

    like what theyre doing.

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    Ownership Structure

    Company Largest

    Shareholder

    Shareholder

    Identity

    Top 20 Shareholders

    BHP 17.22% Nominee 74.48%

    Commonwealth Bank 8.70% Nominee 61.90%

    Westfield 5.01% Company 23.53%

    Singapore Air 56.76% Government 93.83%

    Formosa Plastics 34.12% Family 45.04%

    Hutchison Whampoa 51.79% Family 92.11%

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    Ownership Structure

    The identity of the controlling owner can also havecorporate governance implications.

    Family-controlled companies use cross-holdings and

    pyramidal structures to gain effective control of the

    company with the least cash ownership. The market

    recognizes this and prices the increased risk of

    expropriation into the share price.

    Government-owned and widely-held companies aremore likely to follow the rules.

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    Ownership Structure

    The presence of an non-management relatedblockholder of shares can increase monitoring of the

    firm.

    A blockholder usually holds at least 5% of the

    outstanding shares, therefore has a significant interest

    in the future performance of the company.

    Blockholders can be governments, financial

    institutions, individuals or other companies.

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    External Auditors

    Stock exchange listing requirements usually make itmandatory for companies to employ an external

    auditor to audit their financial statements (and

    internal controls).

    External auditor should be independent of

    management, but .

    Tenure of auditor

    Tenure of audit partner

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    Monitoring by Debt holders

    Debt holders provide capital to the company usuallywith conditions:

    Debt covenants

    Secured on assets

    Therefore debt holders actively monitor management

    to ensure that companies are meeting debt conditions

    and that they wont default.

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    Analysts

    Securities analysts are professionals employed byinvestment banks / brokers / asset managers to

    monitor companies and provide stock

    recommendations (buy/sell), earnings forecasts, long-

    term growth forecasts, target prices etc.

    Provides an extra level of monitoring for investors.

    But, analysts incentives/conflicts of interest meanthat not all of their output is trustworthy.

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    Takeover Market

    The merger and acquisition (M&A) market stands asa court of last resort for assets that are not being

    utilized to their full potential.

    If management are underperforming there is a good

    chance that this will be noticed by the market and

    other players will want to take control of the

    company.

    There are active takeover markets in Australia, US,UK, New Zealand, but few other countries.

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    Intervening Variables

    Measures put in place by companies that restrictshareholder rights and the effectiveness of takeover

    markets:

    Staggered boards

    Limits to by-law/charter changes

    Supermajority requirements for mergers

    Poison pills

    Golden parachutes

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    Legal Systems

    Each countrys legal system has built in a certaindegree of investor protection. However, there is a

    wide variation in protection and enforcement of these

    rules around the world.

    Common law countries provide highest protection

    and French civil law countries provide the least

    protection.

    Low investor protection seems to result inconcentrated ownership and underdeveloped equity

    markets.

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    Legal Systems

    Country Legal System Protection Rule of Law

    Australia Common law 4 10

    France French Civil law 2 8.98

    Germany German Civil law 1 9.23

    India Common law 5 4.17Japan German Civil law 4 8.98

    Korea German Civil law 2 5.35

    Philippines French Civil law 3 2.73

    Netherlands French Civil law 2 10

    UK Common law 5 8.57

    USA Common law 5 10

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    Recent Regulations

    In response to the Enron crisis in the US, theSarbanes Oxley Act was passed in 2002. This has

    significantly increased governance practices and the

    personal liability of directors in the US.

    Most other nations have issued Corporate

    Governance Best Practice Guidelines to assist

    companies in improving their governanceASX

    Corporate Governance Guidelines & Best PracticeGuide (on OLT site). But these are voluntary!

    BHP website BHP Annual report

    http://www.bhpbilliton.com/bb/home.jsphttp://www.bhpbilliton.com/bb/investorsMedia/reports/2006/2006BhpBillitonAnnualReportPage.jsphttp://www.bhpbilliton.com/bb/investorsMedia/reports/2006/2006BhpBillitonAnnualReportPage.jsphttp://www.bhpbilliton.com/bb/home.jsp
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    Convergence?

    Originally there were market-based, family-based,bank-based, government-affiliated systems.

    In recent years, most nations have started to promote

    US and UK best practice corporate governance

    guidelines. But not all companies are adopting these

    measures.

    There is evidence that family-controlled companies

    in particular are refusing to improve their corporategovernance practices.

    Asian Corporate Governance Association

    http://www.acga-asia.org/http://www.acga-asia.org/
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    Measuring Corporate Governance

    Understanding what good corporate governance isabout is quite easy. However, it is difficult tomeasure whether companies are really committed togood governance.

    All we can do is measure if they have certaincorporate governance mechanisms in placewedont know if they are effective or not!

    Organizations such as Standard and Poors and Credit

    Lyonnais Securities Asia have started providingcorporate governance ratings in recent years.

    S&P

    http://www2.standardandpoors.com/portal/site/sp/en/ap/page.article/2,1,1,0,1021558139012.html?vregion=ap&vlang=enhttp://www2.standardandpoors.com/portal/site/sp/en/ap/page.article/2,1,1,0,1021558139012.html?vregion=ap&vlang=en
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    Benefits of Good Governance

    Researchers have shown that companies with goodcorporate governance practices are valued more

    highly and run more effectively.

    So the benefits of good governance include:

    Higher share price

    Lower cost of funds

    Greater international following

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    What you need to remember

    When investing it is worthwhile keeping in mindwhether a company has committed to good corporate

    governance or not. You can use the mechanisms

    highlighted in this lecture or corporate governance

    ratings as a guide.

    Corporate governance becomes most important

    during stock market crashes and bad economic times.

    But, it is not a perfect science. Managers will alwaysfind a way to circumvent monitoring to achieve their

    own goals!